What Does Free and Clear Mean?
Free and clear is a slang phrase describing the situation of someone who gains outright ownership of an asset: That is, it is completely paid off and no creditor has a claim on it. It most frequently applies to real property.
- When an asset is owned completely without debt or liens against it, it is called "free and clear."
- Free and clear most often refers to outright ownership of real property or real estate.
- Free and clear baskets are also a feature of large loans and credit arrangements, representing an extra amount of money a company can borrow without worrying about debt requirements.
Understanding Free and Clear
The phrase "free and clear" is often used when speaking of real estate. It can be a reference to the state of a mortgage. If a homeowner's mortgage is completely paid off and the debt is retired, then the homeowner is said to own the residence "free and clear."
In the case of a home or building that's up for sale, before the deal can close, the property must be "free and clear" so the buyers know that there are no prior claims on it, such as liens (which represent a monetary claim, usually arising from a lawsuit) or other encumbrances. A title search company can be hired to assist prospective owners to ensure that a property has a clear title before proceeding with a transaction. (A property with liens on it is said to have a cloud on title.)
If the owner does not hold a clear title, there may be clauses in their mortgage that accelerate payment to force the loan to be settled before the property can be sold.
How Free and Clear Factors Into Financing
If a homeowner holds their property free and clear, they could make seller financing an option to potential buyers in order to complete the deal. Under such an agreement, the buyer would pay an agreed-upon down payment followed by regular payments to the current owner.
Buyers of property who have the capital available might choose to pay cash to purchase real estate rather than take out a mortgage. That would grant them free and clear ownership of the property and most likely clear title to the real estate.
When real estate is paid off and held free and clear, it is still possible for the owner to take out a new mortgage against the equity they have built up in their home and then use that financing for other purposes. This would put the owner into debt again and remove the free and clear standing of the property.
Pros and Cons of Free and Clear Ownership
Because it's synonymous with being out of debt, free and clear is usually seen as a positive thing. You no longer have interest to pay. When owned outright, your property is better able to serve as collateral for loans or other financing/investment ventures, too.
However, there are a handful of tradeoffs in owning a property free and clear. For example, there may be certain mortgage-based tax breaks that will no longer be available. Buying something with cash to own it free and clear isn't always the most efficient use of funds either, especially if it's a sizable purchase that drains your resources. Sometimes it's better to stay liquid and invest in a variety of assets—what the pros call using leverage.
Also, having a free and clear claim to the property doesn't necessarily mean no one can take it from you, It is still possible that it might be seized by federal or municipal authorities under eminent domain.
The term "free and clear" also sometimes appears as part of an incremental loan facility, a provision in a loan or financing arrangement that allows a borrower to expand the maximum amount allowed on a line of credit (LOC), or to add a term loan to an existing credit agreement. In these deals, there's such a thing as a free and clear or freebie basket. It represents a fixed amount that the borrower is permitted to incur without having to demonstrate pro forma compliance with a financial debt ratio. In other words, it's a pool of funds the borrower can draw on, without having to face debt incurrence tests or leverage other assets. (This is in contrast to another basket of funds offered through the incremental loan facility. This second pool is unlimited in size, but subject to the borrower meeting the debt ratios.)
Free and clear baskets typically involve large-cap companies and loans. The size of the basket will either be "hard capped" at a set amount, or can be "soft capped" as a percentage of the company's earnings before interest, taxes, depreciation, and amortization (EBITDA).